The Difference Between Good Debt and Bad Debt

No debt is better than bad debt.

Yes, those loans are justifiable and beneficial to the borrower.

However, taking on debt carelessly has a negative side.

Although it’s simple to distinguish between these two peaks, certain other debts are more difficult to assess.

Lenders examine your credit report to determine the types of accounts you have.

They treat some obligations more positively than others.

“Good” debt refers to money owed for things that can develop wealth or boost income, like education, mortgages, or business loans.

Credit cards and other consumer debts are examples of “bad” debt because they don’t help you improve your financial situation.

However, these could be exaggerations in some cases.

The differences between “good” and “bad” debt are far more intricate.

What is Good Debt?

The proverb “It takes money to make money” shows how people view good debt as an investment.

You might wonder, “How can something as awful as debt be an investment?”

If the debt you take on helps you earn money and increase your net worth, it’s a win-win situation.

Debt that enhances your and your family’s lives in other ways and contributes to your overall financial health can also be beneficial.

The following are some of the items that are frequently worth going into debt for:

A mortgage

There are numerous methods to profit from real estate.

On the residential front, the most straightforward approach is taking out a mortgage to purchase a property, living in it for a few decades, and then selling it for a profit.

You accumulate equity in your home, and the money you put toward it is an investment.

Many people consider renting an apartment a waste of money, whereas buying a property allows you to develop equity.

This, too, can result in a poor debt decision.

Your mortgage debt can become bad debt if you borrow too much from your property or use your equity to buy things straight immediately.

Read: Tips for Paying Off Debt and Building a Stronger Financial Future

Education

Generally, the higher an individual’s educational attainment, the larger their financial potential.

This may justify the need for a loan.

Education already has a favourable impact on one’s capacity to find work.

Workers with higher education levels are likely to get well-paying jobs.

They also have a better chance of finding new ones if needed.

A college or technology degree can often pay for itself within a few years of joining the workforce.

However, not every degree is treated equally.

So, it’s important to consider the short- and long-term implications of any topic of study that interests you.

You should also keep the quantity of money you borrow to a minimum.

You may be able to shift bad debt into a student loan.

But don’t take more than you need just to have some additional cash.

Business loans

Borrowing money to establish your own business falls under good debt.

It may turn out to be a wise investment.

Whether or not your company becomes the next Facebook, expanding it can help you increase your income.

It is typically both financially and psychologically satisfying to be your own employer.

It can also be extremely taxing. Starting a business, like paying for education, has risks.

Many businesses fail, but choosing an area where you are enthusiastic and competent increases your chances of success.

You may help to ensure that borrowing for your business is a measured risk by planning.

Read: Savings Tips for Millennials: Build Wealth, Not Debt

What is Bad Debt?

Bad debt might lead to more serious financial difficulties in the future.

If you’re borrowing to buy a depreciating asset, it’s usually termed a bad debt.

Put another way, if it won’t increase in value or provide money, you shouldn’t put yourself into debt because of it.

Regarding interest rates, bad debt tends to be more expensive than good debt.

You could end up paying much more than the asset is worth because the payment is spread out over a lengthy period with a high interest rate.

When you take on too much bad debt, it becomes more difficult to get out of the hole later.

Some examples include:

Car loans

Even if you find it difficult to function without a car, borrowing money to purchase one is not a good financial decision.

The automobile is already of less value than when you leave the car lot.

If you need money to buy a car, seek a low-interest or no-interest loan.

You’ll still be investing significant money in a depreciating asset, but you won’t have to pay interest on it.

Read: Debt Management: Strategies for Paying Off Your Loans

Clothes and consumables

Clothing is frequently considered worth less than half of what buyers spend.

Looking around a thrift store, you’ll notice that “half” is an exaggeration.

Of course, you need clothes—as well as food, furniture, and various other items.

But using a high-interest credit card to acquire them isn’t a sensible use of debt.

Use a credit card for convenience.

But make sure you can pay off your full balance at the month’s end to avoid interest costs.

Otherwise, try to make a cash payment.

Credit card debt

Due to the type of things purchased using credit cards, this is usually bad debt.

You shouldn’t use credit to buy necessities such as clothing or food.

If you have to use a credit card for these types of transactions, it should be planned.

For example, to collect rewards fully understanding, you’ll pay off your entire balance on the due date.

It may be tempting to charge a trip on your credit card because you believe taking a break will enable you to be more productive when you return.

Even if it has true advantages, a vacation does not have substantial value.

High-interest loans

Payday loans and certain personal loans with exorbitant interest rates can be termed bad debt.

This is because the high-interest payments are impossible for the borrower to repay.

This leaves them in a worse financial state than before they acquired the debt.

Loans of this nature should be avoided as much as possible.

Read: What are the differences between Debt and Equity Capital

Conclusion

Deciding to take on extra debt is a personal one that involves some research.

This allows you to see if you’ll receive more value out of it than you put in.

You’ll be able to judge better whether or not this additional debt makes sense for you.

To do that, you would’ve calculated the principal payment, interest rate, potential late fees and penalties.

Then, weigh those numbers against the worth of your asset on the other side of repayment.

It’s also important that the recommendations in this blog are not taken as financial advice.

Please seek financial help tailored to your needs from a professional.

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